Australian lenders toughen terms for leverage lords

By Cecile Lefort

SYDNEY (Reuters) - Private equity firms hunting prey in Australia are facing tougher times as once pliant lenders demand higher returns and more protection amid a global repricing of risk.

Banks that finance leveraged buyouts (LBOs) are also under pressure to improve terms when they syndicate the loans to institutional investors, or face burdening their balance sheets with heavy debt.

"Covenants and underwriting standards are being tightened and pricing is moving up," said Bob Sahota, senior portfolio manager at Challenger Financial Services Group, which manages A$3 billion ($2.39 billion) in fixed interest.

The global debt squeeze that has flowed from the U.S. subprime debt crisis had led to mounting concern about leverage buyouts, where buyers load up with debt to buy a company and restructure it, aiming to sell at a profit some years later.

Australian takeover activity surged over the past 18 months, partly fuelled by private equity, making it the largest market for deals in Asia, according to data provider Dealogic.

Standard & Poor's credit analyst Paul Draffin warned in a note in June against an "alarming trend" of debt being provided on increasingly easier terms, heightening risks for investors.

Payment-in-kind notes (PIKs), among the riskier type of bonds, were used in last year's A$1.6 billion ($1.3 billion) takeover of radiology group DCA Group, while a so-called "covenant-lite" structure was part of the failed $9 billion takeover bid for Qantas Airways Ltd. .

Covenant-lite agreements lack traditional restrictions on borrowers, encouraging them to use more debt to fund purchases.

David Goode, portfolio manager at Challenger, said he had looked at LBO deals with gearing levels well above his comfort zone.

"Some of the LBOs had a gearing ratio based on debt to earnings before interest, taxes, depreciation and amortization (EBITDA) of 8, 9 and even 10 times," he said, adding he preferred the range of 5 to 7.

But stricter financial discipline is on the way.

NEW WAVE

JPMorgan's Credit Strategist Craig Saalmann said lenders will want to see restrictions in place, such as an agreed quarterly or half-yearly interest cover ratio or debt-to-cash-flow ratio, before committing credit lines.

"Because of the repricing of risk globally, we are seeing more banks looking at what they are putting on their balance sheet and being selective," he said.

Challenger's Goode said he expects to see more investment incentives such as financial covenants and full cash payouts for investors who buy mezzanine debt -- a risky layer of debt -- along with some exposure to potential share price gains after an initial public offering is launched.

"We want an upside for those investing in mezzanine or convertible debt when the company subsequently launches an IPO," he said.

Another structure meeting resistance in Australia is the relatively new payment-in-kind note, which allows companies to defer interest payments in favor of issuing more debt.

"These instruments are not only deeply subordinated, but cease paying interest well ahead of company default to protect the position of the senior lenders," warned S&P's Draffin.

U.S. discount retailer Dollar General and lawn care service and pest control provider ServiceMaster Co., each taken private last month, had to cancel or delay debt offerings with payment-in-kind features.

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